The online journal of a crusty, longwinded trial lawyer, bemused observer of politics, and internet dilettante

Saturday, March 13, 2010

Be more worried about the amount of federal debt than who holds the debt instruments

Bruce Bartlett has a pretty well-balanced but simple article in Forbes online in which he attempts to answer this question: "Is America's foreign-owned national debt a threat to the U.S. economy?" I agree with both parts of what I understand to be his overall conclusion: The skyrocketing amount of the national debt is an enormous threat to the American economy and, indeed, to America's prosperity and way of life. But there is much less reason, and indeed not very much reason overall, to be concerned that foreign powers, including China, are so heavily invested in American debt securities.

Bartlett does a nice job of clarifying recent changes to both the gross size of the federal debt and the percentage that's foreign-owned  one upshot of which is that a surprising amount, indeed slightly more than half, of the debt instruments (chiefly long-term federal bonds) cumulatively representing that indebtedness are still owned domestically. He explains how China's concentration of ownership represents a deliberate decision by China's central government policymakers to artificially depress the Chinese yuan against the American dollar, which in turn makes Chinese exports relatively less expensive and imports to China relatively more.

As far as generally quantifying the risks of Chinese or other foreign ownership, Bartlett also briefly explains that if the Chinese, or any other large debt holder, were suddenly to dump their U.S. debt security holdings — to liquidate them in the proverbial "fire sale" through open-market transactions with the proverbial "willing buyer [at some price]" — that might well cause a rise in the interest rates America would have to pay on future borrowings. That rising interest rate would of course make our borrowing more expensive, and I don't mean to trivialize the potential damage from that.

The Chinese are probably not unhappy at the prospect that with their relatively safe investment comes some latent and theoretical political power. Sure, it's a plus for them to the extent that there are any scenarios in which they could damage U.S. economic interests. But as Bartlett also notes, those scenarios could only play out if the Chinese were willing to simultaneously absorb huge and probably irreplaceable losses to the principal of their main governmental investment of wealth.

Just how big the impact would be, and how few or many interest rate points would be added, would depend on the spread in the distress sale, along with the availability and eagerness of other buyers. For rational economic actors, interest rates correlate with risk; and unless (or at least until) there is huge structural damage to the American economy, the risk of the U.S. government defaulting on paying its bonds is still lower than that of any other government with remotely the borrowing capacity we have. Indeed, the willingness of the Chinese government, and of other foreign investors who aren't bound by political strings to the Chinese, to continue buying American debt instruments even with almost no interest (and sometimes with an effective negative yield to maturity) during the last couple of years reflects a "flight to quality" in the international investment community. All of this suggests that their are serious intrinsic self-limits to the power of even a meddlesome and spendthrift rival to run up the interest rates on our government debt.

No, the main reason the Chinese — and other foreign investors — have bought into U.S. debt securities so heavily is that they're still the safest and most conservative investment out there. If that changes, we've got big problems all right — but they're not problems limited to, or particularly caused by, the percentage of foreign ownership of our debt instruments.

I might quibble by arguing that Bartlett ignores one specific aspect of the nature of the risk, however. Specifically, in international finance, nation-state players may behave differently from the rational profit-maximizers in classical capitalist theory. We can't make the mistake of presuming that the Chinese will never act contrary to their objective economic self-interests; indeed, for an example of a government which does that routinely, one need look only to neighboring North Korea. There are lots of hypothetical scenarios under which the Chinese could plausibly be imagined to find adequate non-economic reasons to justify incurring those economic costs. And there are somewhat comparable examples in recent history. (Recall, for example, Middle Eastern oil producing companies' sacrifice of short-term profits during the oil embargoes of the 1970s.)

That the Chinese have some sort of power to influence the American economy isn't exclusively a function of their buying our debt instruments, however, but rather is an inevitable function of the sheer size of the other economic transactions going on between China and the rest of the world, most notably including us. If sufficiently motivated to abandon its own economic self-interests in the process, any country of major economic significance could, theoretically, find other ways to damage our economy that didn't involve debt instruments. We wouldn't be immune from rough treatment, in other words, even if we didn't borrow any money from any foreign countries.

In the process of explaining that China's use of its power would carry high costs, Bartlett or his editors stumbled very badly with this stinker of a sentence, however, and in the process omitted a fairly important point:

Further complicating the issue is the fact that the Chinese now own so many Treasury bonds that they are really in the position of being a company's largest shareholder.

Well, no, that's not at all right — not even if we indulge in the useful fiction that in this borrowing transaction, the U.S. government is functioning like a private company. And it's a mistake that feeds into an irrational and unfounded fear, specifically the fear that by buying up our Treasury bonds or other debt instruments, the Chinese might acquire a direct say in what our government does. Such fears ignore the fundamental difference between debt and equity.

A company's largest shareholder is not much at all like its largest bondholder. He who buys a company's bonds gets to stand at the front of the line, ahead of equity holders (like shareholders), if there's a forced liquidation of the company and a distribution of its net assets. But in exchange, the bond holder generally has to forfeit all rights to participate in the management of the company's business unless and until there's a default by the company on its promise to repay according to the terms of the bond. And the caselaw says that companies owe all sorts of fiduciary and other unwritten, vague, but powerful duties to shareholders, whereas companies own nothing more to their debt holders than the precise minimums to which the companies are specifically committed by explicit written contractual promises to the bondholders.

Indeed, federal debt securities don't even include the kinds of negative covenants and restrictions that encumber many private debt offerings. They're not much more than a minimal "IOU," and that sublime simplicity is a fundamental attribute of that kind of investment opportunity.

No matter how many Treasury bonds China buys, it can't somehow "convert" those into a right to cast votes in the U.S. Senate or to give instructions to the Joint Chiefs of Staff. The holder of an American federal bond has a contractual right, enforceable against the U.S. government under its own laws and in its own courts, to repayment of principal and payment of interest on the exact terms specified in the bond. And that's all it has.

Viewed from another angle: The risks discussed above — that China or other current holders might "dump" their holdings, and that China or other potential future investors may refuse to buy without higher interest payments — are essentially built into the terms of the deal, but the trade-off for this kind of borrowing is that it comes without further strings attached. The bondholder may have to stand silent, grinding his teeth, while the borrower runs the business into the ground, but until there's a default, there's nothing the bondholder can do; unlike an aggregation of the shareholders sufficient to represent a majority, the bondholder has no right to replace the management, and hence the bondholder has only minimal and largely theoretical influence over that management. Until the bond's due date, so long as any required periodic interest is being paid, the bondholder's decision tree remains bleak and binary: Hold or sell.

You or I, or General Motors, can't get those kinds of favorable lending terms because we can't justify the same credit rating, in essence, that the U.S. government gets. Lenders want us to put up collateral; they want us to make all kinds of promises about what we will or won't do that might affect our ability to repay. The day may come when the U.S. government can no longer get such favorable terms, either. (Russia, which defaulted on its national debt just before the millennium, certainly can't.) But in assessing the risks — and the limits to the risks — of having foreign governments investing heavily in America's debt instruments, we ought take such comfort as we legitimately can in the fact that our national choices remain, for the present, mostly unconstrained despite the massive debt that Obama and his cronies have already gotten us into. There's already ample cause for concern, and indeed there is already more than ample cause for immediate change (e.g., a return to annual deficits measures increments of less than a quarter-trillion, just for a start). But don't panic, yet, about the Chinese in particular holding so many of our bonds. In any fair prioritization of our national problems, that one is neither one of the biggest nor the most urgent.

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UPDATE (Sat Mar 13 @ 9:45 a.m.): Veronique de Rugy at The Corner also discusses Bartlett's article, and has a useful chart. (H/t InstaPundit, who reprints the chart.)

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Bartlett is a maniac. He oscillates between calm, sensible articles such as the one you've explicated and foaming anti-Geo.W. diatribes The cheerleader for supply side economics in the 1970s and 1980s now bawls for a corrupt form of Keynes that would make Paul Krugman smirk. Such oscillations would do credit to Andrew Sullivan, though their cause is a good deal more mysterious.

You make the good point that nation-states aren't bound to be "rational actors," but I don't think you give enough weight to it. Exempli gratia from China: the coercive power of the state has clamped down a "one child" policy for thirty years. That and the notorious preference for sons has led to a generation where men outnumber women by about three to two. Such a scenario makes Sullivan drool, but should be dam alarming to anyone else. Watch the crime rate in China soar in the next fifteen years. Given the Muslim world's achievements in harnessing single males to violent ends, the Chinese are going to have "interesting times."

The next is the notion that lenders have no rights in buying federal securities. All China has to do is say: no more bonds unless they are denominated in a market basket of currencies. The Feds could roar defiance, but without China in the market, how are future issues to be sold. To be sure, the Chinese would lose a pot of money if they did this, but so what? Since when in Chinese ideology has the welfare of the nation's citizens been high on the list of priorities? If the citizenry has to stand a decade of hard times, the Communist leadership is willing to had them ten years, with time added for bad behavior (always making sure the armed services keep their privileged position in the trough.) Let this nation do without Chinese imports if you want to see hard times!

Looking at the domestic agenda alone of this nation in 2001-2009 does make a good case against Geo. W. But foreign affairs will never be denied. Attempts to do so, as the Billyboy years showed and the election of 2008 is showing, will cost the nation dearly.

One thing that people who complain about the trade deficit should remember: foreign debt is part of the trade deficit. It does not matter whether goods come in shipping container or a wire transfer from a foreign bank, it contributes to the balance of trade.

That is why it is futile to depend upon protectionism to eliminate the trade deficit. Even if the total numbers of shirts, shoes, toothbrushes, cars or whatever we buy from overseas markets, drops to zero every dollar we borrow from the Chinese, Japanese or other foreign investors goes into the deficit side of our balance of trade.

In fact it would make it worse, since imported dollars are a larger part of the trade deficit than imported goods, and by banning imported goods we also zero out our exported goods to foreign nations. (If we won't let their goods here they won't allow our goods there). And the US exports a lot more goods than we import.

JB (#1): Being ostensibly first in line (ahead of general creditors like the carmakers' unions) didn't help Chrysler or GM bondholders, I agree. But that was because of a deliberate and outrageous undermining of the Rule of Law by the Obama Administration, carried out in spite (and not because) of the fundamental nature of the debt securities they held. Compared to Chrysler and GM bondholders, the Chinese can take even less comfort about the likelihood that they'll get their full due under the Rule of Law as purportedly enforced during the Age of Obama.

If you mistake me to be saying "Everything's peachy in general," or worse, "Everything's peachy under Obama," please read this post more carefully, and/or read practically anything else I've ever written about Obama.

Specifically regarding the topic of this post — which is how much we ought to be worried about the Chinese or other foreign powers holding U.S. debt securities — the screw-job to which the Chrysler and GM bondholders mostly consented is a datum that tends to support my argument, albeit to my dismay. There are examples in world history when defaulting countries have literally been invaded and their debts redeemed at bayonet-point, and indeed that happened to our neighbor Mexico in the mid-19th Century. But if we go to war with China, it's not likely to be over that. (We didn't invade Russia when they defaulted on their national debt a few years ago, even though Americans who'd invested in Russia were among those most badly ripped off.)

Why are we concerned when it's us who has their money? We are only concerned because, and to the extent that, we (the American people) honor (both morally and legally) our promises — in this case, as represented by the express terms of the bonds.

I agree that the current Executive and his Administration share a profound disregard for morality and law, and that the bondholder cram-downs associated with the federalization of the auto industry and bailout of its unions were shameful. But there's nothing in that sordid story which ought to make us particularly worried that the Chinese own lots of U.S. Treasury bonds. (There is indeed something in the story which ought to worry the Chinese, however; presumably it does, but not yet to the point that they've begun to disinvest.)

Davod (#5), those are wonderfully clear questions that embarrass me, because I thought I'd answered them, and if I did, I didn't do so with anything remotely like the clarity of your questions.

Yes, if China's leaders made a political decision to hurt the U.S. economy despite the economic damage it would also do to China, they could use their debt holdings for that. Unless there has been a default by the U.S., their choice, like other bondholders' choice, is to either hold or sell. They could sell in a hurry, which would have the likely effect of driving up the price the U.S. Treasury has to pay on its future bond issues. (The drop in price on the existing bonds would affect the market, but not the U.S. Treasury directly, since its repayment obligations are independent of what price the bonds are sold at in the secondary market.)

My intention in this post was to throw cold water on fears of this scenario because I don't think it's a realistic one. There are several reasons that I think are unrealistic.

To begin with, the economic harm the Chinese would have to absorb would be a large multiple of the harm they'd be inflicting upon the U.S. If they dumped their entire position, they'd be destroying a huge amount of their own national capital. The negative effects on the Chinese economy would almost certainly be a large multiple of the effects on the American economy; and to the extent that the entire world's economy is shaken, that, ironically (from the Chinese point of view) would tend to improve America's position simply because it would still be perceived as the safest investment in an economic firestorm. (If you're willing to give up interest because there are no other safe investment opportunities that can even guarantee convincingly the return of your principal, that's when you most want to buy T-bills.)

Cutting off their own noses to spite their faces is the sort of perverse and non-economic behavior that we're still used to seeing from North Korea, for example, and its also the sort of behavior we saw from Mao himself (in the Great Leap Forward and Cultural Revolution). But it would be very, very atypical behavior for the current Chinese leadership. The reason their economy has become robust enough for this to become even a theoretical threat is because they've been making economic decisions that are mostly rational and avoiding non-economic decisions that would threaten their economy.

If the Chinese were intent on hurting our economy even at the expense of destroying their own, there would be better ways — most cost-effective ways — for them to try to do that than by dumping our bonds.

My friend Mr. Koster (#2 above) hypothesizes a less self-destructive attempt by the Chinese to throw their economic weight around:

All China has to do is say: no more bonds unless they are denominated in a market basket of currencies. The Feds could roar defiance, but without China in the market, how are future issues to be sold?

But he's got exactly backwards who still has the larger economy, and who has the practical power. Yes, the Chinese have already made threatening noises about making something other than the dollar into a new international standard, but that (i.e., threaten vaguely) is all they've been able to do. The sheer size of the market would prevent any other currency — including their own — from taking the dollar's place, and the yuan in particular is already, as noted above, artificially low against all other currencies because of deliberate decisions made by the Chinese government to promote their own export industries and discourage imports. The second-place world currency by volume, the Euro, is already tottering on the brink of collapse itself, depending on whether and to what extent the Germans are willing to bail out the Greeks. If the U.S. dollar is Cinderella, the poor but beautiful and virtuous girl who's worked her way up to become princess, she's still who everyone wants to dance with, and a coalition of ugly step-sisters just magnifies the ugly. We're going to have to get a lot more ugly before rational economic decision-makers are going to prefer putting their investments into Greece, Spain, or even Italy, where the risk of government default is palpable rather than theoretical.

Come the day when the Chinese say, "We're not buying any more American Treasury bonds," that doesn't mean no one else will buy them either. To increase demand for our government bonds, we might indeed have to pay considerably higher interest than we have been. But the market for investment-grade securities includes private alternatives, and the total market is vastly larger than just the part of it that presently resides in U.S. government bonds. Confronted with the choice between a private bond issue at 10% and a U.S. Treasury bond issue at 10%, the rational public or private investor world-wide would go for the Treasury bonds. The premise of Mr. Koster's hypothetical — that we'd have no buyers at all for our bonds without the Chinese, regardless of the interest we pay — is simply false.

No, with due respect, for even the scenario Mr. Koster imagines to play out, America would have to first complete the destruction of its own economy through unproductive deficit spending, heavy taxation, and the resulting stagflation. Thus, a ten trillion-dollar U.S. federal deficit over the next decade will do vastly more to move us toward that unhappy juncture than anything the Chinese might dream of doing from their position as bondholders.

I'll leave Ray Bolger to clean up after all the straw men you've hurled at me, and dtry to answer your arguments:

1. China is an authoritarian country with a lower standard of living than the US. They can stand a lot more economic pain than the US can, just as the North Vietnamese withstood the far great knocks of war that we Americans gave them.

2. I don't doubt that the US Treasury could sell its debt even if the Chinese withdrew. But at what interest rate? Remember, the Treasury rate is the "risk free" rate. If it rises, all other interest rates rise. What would 8% T-bill rates and corresponding 13% prime interest rates do to the American and world economies in their present states. China doesn't have to stop a single bond from being sold. It just has to raise the price the Treasury pays, a raise that will rapidly flow through to the rest of the price structure.

3. China's economic "rationality" is the rationality of the pirate. The systematic undervaluing of currency is a sophisticated form of "beggar your neighbor," that has gone on only because the American government can't kick the debt habit, thanks to ninnies like Krugman bawling that Keynes was right, governments can't go bust. The "rationality" looks even more hollow when you consider the legal framework. China may be entrusted with manufacturing, because there is a tangible product. But who in their right mind would trust China on intellectual property deals? China is notorious for IP piracy, and no one trusts its legal system to deal with such issues. Nor is it clear how these problems can be resolved without tossing the system of government in the ash can.

4. China has a serious medium and long term problem, fast approaching: thanks to a combination of the "one child" policy for families and cultural preferences for sons, a generation is coming up where the males outnumber the females by about three to two. This makes Sullivan drool, but it's dam alarming to think about. Such an excess of young males can have hideous consequences now, e.g. the crime rate. But it will also skew any long term social arrangements, e.g. pensions. So China is in for rough times starting about 2015, and going on for decades.

5. China looks at the world, with a big economy, lots of foreign exchange, and long term problems that won't quit. (The sex imbalance is one big reason China wants Taiwan back. Taiwanese women would help the imbalance a little, not much.) It sees America in a trough, burdened with debt, and an administration headed by an arrogant dolt, who refuses to learn from experience or any other means. When will there be a better time?

How likely do I think China is to throw its currency weight around? It's a longish shot. I'll quantify it for you: I think this course of weight throwing is as likely as the US Treasury losing its "risk free" credit rating in the next five years. This alarms me. I think you need to worry a bit more about Chinese weight throwing.

I also dislike your "America has the biggest economy and markets, and that can't be disregarded," argument. You are quite right, but that's a lousy argument to advance. It reeks of complacency, of General Motors in the 1950s, or IBM in the 1970s. It also gets in the way of the real solution to Chinese weight throwing: getting our own affairs in order. You could not be more right when you write:

"Worry about Obama."

But my worry is less about his idiotic domestic policies than his insane complacency about foreign affairs. What he's done to Great Britain is horrifying. It cause the release of the Lockerbie bomber. Now we retaliate by assuming neutrality in re the Falklands and Argentina. What The One has done to India and its relations with the US, is also bad news. Unfortunately, its much harder to battle The One on foreign affairs than to raise a Tea Party and denounce his domestic idiocies.

I read this after you posted it and it's even more helpful the second or third time around. You convinced me in theory, but I admit that I'm still worried about almost everything. On the plus side, China is the least of my worries.

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